Charles Rex Arbogast

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The People's Panic

An excerpt from a new collection of essays, Panic: The Story of Modern Financial Insanity, edited by Michael Lewis the author of Liar's Poker. He contributes several essays to the book, including the one here, “The People’s Panic.”

11.26.08 5:37 PM ET

One difference between previous financial panics and the real estate and subprime-mortgage collapse is the sheer number of people involved. “No money down” was an invitation for people far away from Wall Street to take Wall Street-like risks. Just about everyone in America could afford no money down. It wasn’t a financial market that panicked, it was the larger society; and the list of people and ideas that could plausibly be blamed for the mess was long: ratings agencies, mortgage brokers, mortgage originators, Bill Clinton. Gretchen Morgenson at the New York Times blamed Wall Street, for exploiting the middle class. Wall Street people—who lost a lot more money than the poor—blamed their CEOs. The brokers at Merrill Lynch blamed Stan O’Neal, and bankers at Bear Stearns blamed Jimmy Cayne. I wrote a satirical piece…blaming poor people. Seen from the point of view of a rich hedge fund trader, the subprime-mortgage mess looked like a gigantic con perpetrated upon rich people, such as himself, by the poor, who had the hedge fund manager–like audacity to take whatever money was offered to them. Few saw the satire. Some readers were upset by the callousness of hedge fund traders. Many agreed with me, and hoped I’d run for president and teach the poor a lesson.

How many times does the end of the world as we know it need to arrive before we realize that it’s not the end of the world as we know it?

The 1987 stock market crash was blamed on program trading; the Asian currency crisis was blamed on some combination of hedge funds and IMF-induced policies; the Internet bubble was blamed on Wall Street analysts. The subprime-mortgage panic has yet to find its one big culprit, and I’m not sure it ever will. I’ve tried hard to include a glimpse of all the putative villains, but the task has proved impossible. I’ve failed to locate, for instance, anything really interesting written about several of the Wall Street CEOs who led their firms to oblivion. On the other hand, a lot of great stuff has been written and said about this mess…

Just now there’s a feeling in the air that the American financial system has reached some kind of terminus… It’s one thing to need money to tide you over until the next payday. It’s another to need money because there are no more paydays. In this crisis, unlike the previous three, our problem is not liquidity but solvency. We can’t afford to run our financial system in this manner. Another difference between this panic and the others is the sheer amount of destruction it’s caused inside big Wall Street firms. As of this writing one big firm has collapsed, five CEOs have been fired, 50,000 Wall Street jobs have been lost, and Wall Street shareholders have lost more than a trillion dollars. It’s unlikely that markets will allow the big firms to indulge in the same leverage as they have, or to use complexity to hide the risk being taken. It’s going to be hard for them to get into this much trouble again any time soon.

But that doesn’t mean that the game is over. Since the crash of 1987, when the government set out explicitly to prevent this sort of thing from happening again, the cycles of euphoria and panic have become more and more thrilling: whoever has been seeking to minimize drama in the financial markets has been doing a poor job of it. Step back from it and you can’t help but wonder if anyone is really trying. If perhaps this is the nature of global capitalism—ever more complex, ever more opaque, ever faster booms and busts—and it’s not the markets that need to change but our reaction to them. How many times does the end of the world as we know it need to arrive before we realize that it’s not the end of the world as we know it?

At the bottom of the modern financial markets are the incentives that people who manage money have been allowed to create for themselves by investors who continue to place far too much faith in their wisdom. Our allocators of capital, when they make huge sums of money, are allowed to keep a huge chunk of the winnings; if they lose a huge sum of money, they walk away debt-free—and create another hedge fund…Before the subprime collapse, the big Wall Street firms had turned themselves into giant hedge funds, with their profits, increasingly, coming from their trading. It’s easy to imagine this changing, and these firms becoming less risky and less profitable businesses, and the people inside them making a lot less money. It’s harder to imagine the people who are taking home tens of millions of dollars a year for themselves by making big bets with other people’s money becoming glorified bank tellers. More likely, the subprime-mortgage panic will accelerate the trend of the action moving out of these bigger firms into smaller hedge funds.

The critical document from this drama—the takeaway—may be…a Wall Street Journal piece…that introduced the world to John Paulson. A hedge fund manager no one had ever heard of, Paulson took home $3.7 billion for himself shorting subprime mortgages. That is more money than anyone has ever made on Wall Street in a year; and you can bet his example has not been lost on others. Just the other day an item flitted across the news wires: Josh Birnbaum, one of the traders at Goldman Sachs who shorted the subprime-mortgage market, made the firm $4 billion, and helped it to avoid the same fate as other Wall Street firms, announced his resignation. He planned to raise a billion dollars and start his own hedge fund to invest in mortgage securities. To get whatever he wanted, everyone seemed to agree, he needed only to snap his fingers.